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Answers to End-of-Chapter Questions

1. There would be adverse selection because people who might want to burn their property for some personal gain would actively try to obtain substantial fire insurance policies. Moral hazard could also be a problem because a person with a fire insurance policy has less incentive to take measures to prevent a fire. 2. Chartering banks is the bank regulation that helps reduce the adverse selection problem because it attempts to screen proposals for new banks to prevent risk-prone entrepreneurs and crooks from controlling them. It will not always work because risk-prone entrepreneurs and crooks have incentives to hide their true nature and thus may slip through the chartering process. 3. Regulations that restrict banks from holding risky assets directly decrease the moral hazard of risk taking by the bank. Requirements that force banks to have a large amount of capital also decrease the banks incentives for risk taking because banks now have more to lose if they fail. Such regulations will not completely eliminate the moral hazard problem because bankers have incentives to hide their holdings or risky assets from the regulators and to overstate the amount of their capital. 4. The benefits of a too-big-to-fail policy are that it makes bank panics less likely. The costs are that it increases the incentives of moral hazard by big banks who know that depositors do not have incentives to monitor the bank's risk-taking activities. In addition, it is an unfair policy because it discriminates against small banks. 5. Because off-balance-sheet activities do not appear on bank balance sheets, they cannot be dealt with by simple bank capital requirements, which are based on bank assets, such as a leverage ratio. Banking regulators have dealt with this problem by imposing an additional risk-based bank capital requirement that banks set aside additional bank capital for different kinds of off-balance-sheet activities. 6. Because with higher amounts of capital, banks have more to lose if they take on too much risk. Thus capital requirements make it less likely that banks will take on excessive risk. 7. Bank supervision involves bank examinations in which examiners assess six areas of the bank represented in the CAMELS rating (capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk). A low score on the CAMELS rating allows the supervisors to declare a bank to be a problem bank, making it more subject to frequent examinations and to sanctions to reduce the amount of risk taking it is engaged in. Bank examiners also check that the bank is following the rules and regulations and is not holding securities or loans that are too risky. All of these measures help ensure that banks are not taking on too much risk, and thus promote a safer and sounder banking system. 8. The Bank Insurance Fund of the FDIC was recapitalized by allowing it to borrow more from the Treasury and by raising insurance premiums. The bill reduced the scope of deposit insurance by limiting brokered deposits and by limiting the too-big-to-fail doctrine by forcing the FDIC to use the least cost method of closing failed banks except under unusual circumstances. The bill has prompt corrective action provisions that requires the FDIC to intervene earlier with stronger actions when banks move into one of the weaker of the five classifications based on bank capital. The limiting of deposit insurance and prompt corrective action should reduce moral hazard risk-taking on the part of banks. The bill instructs the FDIC to come up with risk-based premiums which will increase the premium cost when the banks take on more risk, thus helping to reduce the moral hazard problem. The bill also mandates increased reporting requirements and annual examinations to prevent the banks from taking on too much risk. It also enhances regulation of foreign banks in the U.S. to keep then from operating in the U.S. if they are taking on too much risk

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9. With the advent of new financial instruments, a bank that is quite healthy at a particular point in time can be driven into insolvency extremely rapidly from risky trading in these instruments. Thus, a focus on bank capital at a point in time may not be effective in indicating whether a bank will be taking on excessive risk in the near future. Therefore, to make sure that banks are not taking on too much risk, bank supervisors now are focusing more on whether the risk-management procedures in banks keep them from excessive risk taking that might make a future bank failure more likely. 10. More public information about the risks incurred by banks and the quality of their portfolio helps stockholders, creditors and depositors to evaluate and monitor banks and pull their funds out if the banks are taking on too much risk. Thus, in order to prevent this from happening banks are likely to take on less risk and this make bank failures less likely. 11. Eliminating or limiting the amount of deposit insurance would help reduce the moral hazard of excessive risk taking on the part of banks. It would, however, make bank failures and panics more likely, so it might not be a very good idea. 12. In general, yes. A national banking system will enable banks to diversify their loan portfolios better, thus decreasing the likelihood of bank failures. In addition it may make banks and hence the economy more efficient and will help increase banks profitability which will make them healthier. 13. The economy would benefit from reduced moral hazard; that is, banks would not want to take on too much risk because doing so would increase their deposit insurance premiums. The problem is, however, that it is difficult to monitor the degree of risk in bank assets because often only the bank making the loans knows how risky they are. 14. Market-value accounting for bank capital would let the deposit insurance agency know quickly if a bank was falling below its capital requirement so that it could be closed down before it led to substantial losses for the insurance agency. Also it would help keep banks from operating with negative capital when the moral hazard problem becomes especially severe and the bank takes on excessive risk. However, making accurate market-value calculations of bank capital is a complex task since it would require some estimates and approximations. However, even if not fully accurate, if market-value accounting provides a more accurate assessment of bank capital than historical-cost accounting, it would lead to lower losses from the deposit insurance agency.

Quantitative Problems
1. Consider a failing bank. A deposit of $150,000 is worth how much if the FDIC uses the payoff method? The purchase and assumption method? Which is more costly to tax payers? Solution: Under the payoff method, large deposits pay better than $0.90/dollar. In this case, the $150,000 is worth better than $150,000 0.90 = $135,000. Under the purchase and assumption policy, the bank is completely absorbed, and all accounts are worth their full value. Upfront, the second method will have a lower cost to the insurance fund. However, if depositors fear loss under the payoff method, they are less likely to maintain account balances in excess of $100,000 in a single bank.

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2. Consider a bank with the following balance sheet: Assets Required Reserves Excess Reserves T-bills Mortgages Commercial Loans $ 8 million $ 3 million $45 million $40 million $10 million Liabilities Checkable Deposits Bank Capital $100 million $ 6 million

Calculate the banks risk-weighted assets. Solution: Reserves and T-bills have a zero weight. So, $56 million has zero weight. Mortgages carry a 50% weight. RW Assets = $40 million 0.50 = $20 million. Commercial loans carry a 100% weight. RW Assets = $10 million. Total risk-weighted assets = $30 million. 3. Consider a bank with the following balance sheet: Assets Required Reserves Excess Reserves T-bills Commercial Loans $ 8 million $ 3 million $45 million $50 million Liabilities Checkable Deposits Bank Capital $100 million $6 million

The bank commits to a loan agreement for $10 million to a commercial customer. Calculate the banks capital ratio before and after the agreement. Calculate the banks risk-weighted assets before and after the agreement. Solution: Before the agreement, the capital ratio = 6/106 = 5.66%. Since the loan agreement has no accounting transaction, the capital ratio is the same after. For risk-weighted assets: Reserves and T-bills have a zero weight. So, $56 million has zero weight. Commercial loans carry a 100% weight. RW Assets = $50 million. Total risk-weighted assets = $50 million. After the loan agreement, risk-weighted assets: Reserves and T-bills have a zero weight. So $56 million has zero weight. Commercial loans carry a 100% weight. RW Assets = $50 million. Commercial loan commits are at 100%. RW Assets = $10 million Total risk-weighted assets = $60 million. The actual risk-weighted assets for the loan commitment may vary depending on the terms of the commitment and other factors. However, under the idea of risk-weighted assets, the $10 million would be correct.

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4. Oldhat Financial started its first day of operations with $9 million in capital. $130 million in checkable deposits are received. The bank issues a $25 million commercial loan and another $50 million in mortgages, with the following terms: mortgages: 200 standard 30-year, fixed-rate with a nominal annual rate of 5.25% each for $250,000 commercial loan: 3-year loan, simple interest paid monthly at 0.75%/month If required reserves are 8%, what does the bank balance sheets look like? Ignore any loan loss reserves. How well capitalized is the bank? Solution: Assets Required Reserves Excess Reserves Loans $10.4 million $53.6 million $75 million Liabilities Checkable Deposits Bank Capital $130 million $ 9 million

The bank is well capitalized, at 9/139 = 6.47% 5. Calculate the risk-weighted assets and risk-weighted capital ratio of Oldhats first day. Solution: Reserves have a zero weight. So, $64 million has zero weight. Residential mortgages carry a 50% weight. RW Assets = $25 million. Commercial loans carry a 100% weight. RW Assets = $25 million. The capital ratio = 9/50 = 18%. 6. The next day, terrible news hits the mortgage markets, and mortgage rates jump to 13%. What is the market value of Oldhats mortgages? What is Oldhats market value capital ratio? Solution: When issued, the required payment is: PV = $250,000, I = 5.25/12, N = 360, FV = 0 Compute PMT. PMT = $1,380.51 After the rate increase, the mortgages are worth: PMT = $1,380.51, I = 13/12, N = 360, FV = 0 Compute PV. PV = $124,797.56, or a loss of about 50% of value. The new market value balance sheet is: Assets Required Reserves Excess Reserves Loans $10.4 million $53.6 million $50 million Liabilities Checkable Deposits Bank Capital $130 million $16 million

However, the loss would not be immediately recognized. No actual accounting transaction would take place.

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7. Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What is the accounting transaction? How does this affect its capital position? Solution: The sale of each mortgage would be recorded as: Debit Cash Loss $124,798 $125,202 Mortgages Credit $250,000

After the fact, the actual balance sheet is: Assets Required Reserves Excess Reserves Loans $10.4 million $78.6 million $25 million Liabilities Checkable Deposits Bank Capital $130 million $16 million

Now, the true state of the banks position is realized. 8. Congress allowed Oldhat to amortize the loss over the remaining life of the mortgage. If this technique was used in the sale, how would the transaction have been recorded? What would be the annual adjustment? What does Oldhats balance sheet look like? What is the capital ratio? Solution: The sale of each mortgage would be recorded as: Debit Cash Capitalized Loss $124,798 $125,202 Mortgages Credit $250,000

Then, each year for the next 30 years, the loss would be written off: Debit Loss (Expense) $4,173.40 Capitalized Loss Credit $4,173.40

After the fact, the actual balance sheet is now: Assets Required Reserves Excess Reserves Capitalized Loss Loans $10.4 million $78.6 million $25 million $25 million Liabilities Checkable Deposits Bank Capital $130 million $ 9 million

The bank is again well capitalized, at 9/139 = 6.47%

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9. Oldhat decides to invest the 78.6 million in excess reserves in commercial loans. What will be the impact on its capital ratio? Its risk-weighted capital ratio? Solution: With the commercial loan, the balance sheet is now: Assets Required Reserves Excess Reserves Capitalized Loss Loans $10.4 million $0 million $25 million $103.6 million Liabilities Checkable Deposits Bank Capital $130 million $ 9 million

The bank is still well capitalized, at 9/139 = 6.47%. For risk-weighted: Reserves have a zero weight. So, $10.4 million has zero weight. The remaining balance sheet is at 100%, or $128.6 million. The risk-weighted capital ratio = 9/128.6 = 7%. 10. The bad news about the mortgages is featured in the local newspaper, causing a minor bank run. $6 million is deposits are withdrawn. Examine the banks condition. Solution: The balance sheet is now: Assets Required Reserves Excess Reserves Capitalized Loss Loans $4.4 million $0 million $25 million $103.6 million Liabilities Checkable Deposits Bank Capital $124 million $ 9 million

The bank is still well capitalized, at 9/133 = 6.76%. However, the required reserve ratio is 8%, or $9.92 million. The bank is roughly $5.5 million short. 11. Oldhat borrows $5.5 million in the overnight fed funds market. What is the new balance sheet for Oldhat? How well capitalized is the bank? Solution: The balance sheet is now: Assets Required Reserves Excess Reserves Capitalized Loss Loans $9.9 million $0 million $25 million $103.6 million Liabilities Checkable Deposits Fed funds borrowed Bank Capital $124 million $ 5.5 million $ 9 million

The bank is still well capitalized, at 9/138.5 = 6.5%